Saving for college and higher education is something most every family has to think carefully about. The cost of college has skyrocketed over the last decade, leaving most young families planning for their children’s education before they’re even born.
There are several account types (usually called “vehicles”) that you may want to look into if you are interested in setting aside some money for future education; the two most common are the 529 and the Coverdell Education Savings Account (ESA). Both have their merits, but have important distinctions you should know about.
When deciding which may be right for you, let’s think about these 4 introductory questions.
What are Qualifying Expenses?
When you withdraw money from either of these accounts, to preserve their tax status, they must be put towards qualifying expenses.
Here lies a key difference between the 529 & the ESA: The 529 requires that proceeds be put toward education after secondary school, while the ESA allows for qualifying expenses related to elementary and secondary school as well (most often for private school).
Are there limits to contributions?
The contribution limits are simple for an ESA – it’s capped at $2,000 per year.
529s do not have established contribution limits set by the IRS, as these accounts are sponsored by states themselves. For instance, in South Carolina, 529 contributions cannot exceed $426,000 for a single beneficiary. However, bear in mind if you may be opening yourself up to gift tax issues if you contribute more than the yearly exclusion amount (currently $14,000).
What are the tax consequences?
Firstly, contrary to what many people believe, neither account offers you a tax deduction for a contribution. You don’t receive that deduction because so long as you use the account for qualifying educational expenses, the withdrawals are tax free, even the earnings.
If you end up not utilizing the account for qualifying expenses, prepare to not only pay tax on the earnings, but also a 10% penalty on the earnings themselves.
Are there financial aid ramifications?
If you have kids in, or already finished, with college, you know how crucial the financial aid process can be. A few thousand dollars here and there can make a large difference in determining how much aid the school gives a student.
The federal financial treatment for the 529 and the ESA are identical. Most likely the account is owned by the parent for the benefit of the child, meaning it shows up as an asset of the parent. Furthermore, qualified withdrawals do not count as income towards financial aid determination.
Always remember there is no “one size fits all” college savings vehicle. Some will appreciate the flexibility of the ESA for primary and secondary school, while others will find the ESA too restrictive in their contribution limits and decide to open a 529.
529s and ESAs are far from the only vehicles people use for education savings; some utilize qualified US savings bonds, custodial accounts (UGMA/UTMA), and even IRA accounts.
Regardless of how you choose to help loved ones pay for their education, the most important thing to remember is to start soon. The power of compounding will certainly help offset the ever rising costs of education in our country.